Northrop Grumman - Stock Analysis

In this Northrop Grumman Stock Analysis, I look at whether NOC is currently an attractive investment opportunity.

Information Sources

The following are links to my sources to aid in your own analysis.

Part 1 of the FY2020 10-K has a good overview of NOC's major businesses, customers, business strategy, solutions and risks. Additional information is also available in the:

Northrop Grumman - Stock Analysis - Industry Overview

Sadly, our world becomes increasingly dysfunctional and peace in our time is highly unlikely. Given my outlook, I think leading global aerospace and defence companies are likely to be attractive long-term investments; I currently have exposure to Lockheed Martin (LMT), Raytheon Technologies (RTX), and HEICO (HEI and HEI-a).

I like these companies because the barriers to entry are extremely high. Defence budget allocation, for example, is a lengthy and unpredictable political process. Industry participants also deal with highly classified programs which raise the bar for potential new entrants.

One readily apparent risk is the concentration of sales to various US government departments; this is typical for leading US aerospace and defence companies.

Some of NOC's primary competitors in the defence, intelligence and federal civil markets are:

  • Lockheed Martin;
  • Raytheon Technologies;
  • Boeing Company; and
  • General Dynamics;

Key characteristics of the industry include long operating cycles and significant competition. This is borne out through the number of competitors bidding on program opportunities and the number of competitor bid protests of US government procurement awards.

According to page 7 of 137 in the FY2020 10-K:

'It is common in the defence industry for work on major programs to be shared among a number of companies. A company competing to be a prime contractor may, upon ultimate award of the contract to another competitor, become a subcontractor to the ultimate prime contracting company. It is not unusual to compete for a contract award with a peer company and, simultaneously, perform as a supplier to or a customer of that same competitor on other contracts, or vice versa.'

Furthermore, this industry is characterized by:

  • customer-paid R&D;
  • regulated margins;
  • mature markets: and
  • long-term revenue visibility.

This allows companies such as LMT, RTX, and NOC to distribute a considerable degree of cash generated.

Northrop Grumman - Stock Analysis - Business Overview

NOC is currently aligned in 4 operating sectors and reportable segments: Aeronautics Systems, Defense Systems, Mission Systems and Space Systems.

NOC's largest customer is the US government: 84%, 83%, and 82% of sales during FY20202 - FY2018.

A disproportionate level of NOC's business comes from the US government but no single program accounts for more than 10% of total sales in recent years.

The major defence contractors have sizable backlogs and NOC is no exception. On December 31, 2020, NOC's remaining performance obligations were $81.0B versus $64.8B on December 31, 2019.

The national defence strategy is increasingly focused on modernization. I expect budget compromises with defence budget spending to benefit from cuts to non-defence budgets.

An attractive feature of an investment in a defence contractor is that many programs are procured and sustained over decades. The Ground Based Strategic Deterrent (GBSD), for example, is to be deployed around 2029 and to be active until roughly 2075; the US Air Force’s (GBSD) is the weapon system replacement for the ageing LGM-30 Minuteman III intercontinental ballistic missile system (ICBM).

We also see from the March 23, 2021 Press Release that NOC:

'has been awarded a contract by the Missile Defense Agency (MDA) for the Next Generation Interceptor (NGI) program. The contract is for the rapid development and flight test of an interceptor designed to defend the nation against the most complex long-range threats. NOC has strategically teamed with Raytheon Missiles & Defense, a business of RTX, to bring together the vast experience of the two companies on one team, to deliver an effective solution for MDA on an accelerated schedule.'

Northrop Grumman - Stock Analysis - Financials

Q1 2021 Results

In Q1, NOC was awarded $8.9B of new business and increased sales ~6.23% from Q1 2020. It also completed the previously announced sale of its IT and mission support services business for $3.4B in cash and recorded a pre-tax gain on the sale of $1.98B.

The $13.43 GAAP EPS includes a $12.11/share gain from the sale of the IT and mission support services business. Exclude this sale and adjusted diluted Q1 EPS is $6.57.

Using cash on the balance sheet and divestiture proceeds, NOC executed a $2B accelerated share repurchase agreement that retired 5.9 million shares. It also retired $2.2B in debt, including early redemptions of $1.5B. Even after more than $4.4B of share repurchases, dividends and deleveraging, NOC ended Q1 with $3.5B cash on the balance sheet.

FY2021's capital deployment plans continue to include investments to drive innovation and at least $1B of additional share repurchases.

As noted earlier, the industry benefits from long-term revenue visibility. On the Q1 earnings call with analysts, management indicated that based on the outlook over the next couple of years, the majority of Free Cash Flow (FCF) is expected to be returned to shareholders through share repurchases and dividends.

FY2021 Guidance

Following a strong Q1 and solid outlook for the remainder of FY2021, sales guidance is now $35.3B - $35.7B versus the prior $35.1B - $35.5B range.

In addition, adjusted diluted EPS guidance is now $24 - $24.50 versus the prior $23.15 - $23.65 range.

Operating Cash Flow (OCF) Free Cash Flow (FCF)

NOC's FY2011 - 2020 OCF was $2.115B, $2.64B, $2.483B, $2.593B, $2.162B, $2.813B, $2.613B, $3.827B, $4.297B, and $4.305B.

FCF during the same timeframe was $1.623B, $2.309B, $2.119B, $2.032B, $1.691B, $1.893B, $1.685B, $2.578B, $3.033B, and $2.885B.

Looking at FY2021 guidance (see above), NOC expects to generate ~$3B — ~$3.3B of transaction-adjusted free cash flow for the year. This level is consistent with FCF in recent years.

Northrop Grumman - Stock Analysis - Credit Ratings

Merely looking at stock charts or stock screeners is not investing. Investing properly is very time-consuming. It entails the review of:

  • quarterly and annual financial reports;
  • investor presentations;
  • reading the transcripts of management discussions with members of the investment community; and
  • reading about what is happening in the industry.

I, therefore, prefer to primarily focus on high-quality companies.

By minimizing time to ascertain the degree to which an investment exposes me to a permanent impairment to my capital, I can allocate more time to analyzing an investment's potential investment return. Looking at ratings assigned by the major credit rating agencies helps me in this regard.

Moody's upgraded NOC's domestic senior unsecured long-term debt from Baa3 to Baa2 in November 2004 and to Baa1 in June 2007.

S&P Global affirmed a BBB+ rating in March 2021.

Fitch downgraded NOC from BBB+ to BBB in October 2017 but subsequently affirmed this BBB rating a few times, most recently in March 2021.

The Moody's and S&P Global's ratings are the top tier of the lower medium grade investment-grade category. Fitch's rating is 1 notch lower.

All 3 ratings define NOC as having an ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to NOC having a weakened capacity to meet its financial commitments.

The following, for comparison, are LMT's and RTX's domestic senior unsecured long-term debt ratings.

LMT

  • Moody's: A3 (upgraded from Baa3 to Baa2 in December 2001, upgraded to Baa1 in January 2006, upgraded to A3 in December 2019)
  • S&P Global: A- (rating assigned in May 2019 and affirmed May 2021)
  • Fitch: A- (upgraded from BBB+ in June 2019)

RTX

  • Moody's: Baa1 (downgraded from A2 to A3 in September 2015 and further downgraded to Baa1 in August 2018)
  • S&P Global: A- (rated April 2020 and under review with negative implications)
  • Fitch: ratings were withdrawn following Raytheon and United Technologies merger

LMT's ratings are the best of the 3 while the ratings for RTX and NOC are reasonably similar.

Northrop Grumman - Stock Analysis - Dividends and Share Repurchases

Dividend and Dividend Yield

Looking at NOC's dividend history, we see an ~8.3% dividend increase from $1.45/share/quarter to $1.57/share/quarter was announced May 18, 2021.

The new dividend yield of ~1.7%, based on the current ~$367.20 share price, will likely dissuade some investors from investing in NOC.

NOC's outlook is such that I am not concerned about sustained dividend growth.

Stock Splits and Share Repurchases

Stock splits are included in the dividend history section of the company's website.

On September 16, 2015, NOC’s Board of Directors authorized a share repurchase program of up to $4.0B. Repurchases under this 2015 Repurchase Program commenced in March 2016 and were completed in March 2020.

On December 4, 2018, NOC’s Board of Directors authorized a share repurchase program of up to an additional $3.0B. Repurchases under the 2018 Repurchase Program commenced in March 2020 upon the completion of the 2015 Repurchase Program. There were no repurchases of common stock during Q4 2020 and as of December 31, 2020, repurchases under the 2018 Repurchase Program totalled $0.2B; $2.8 billion remained under this share repurchase authorization. The 2018 Repurchase Program is set to expire when all authorized funds for repurchases have been used.

On January 25, 2021, NOC’s Board of Directors authorized a share repurchase program of up to an additional $3.0B in share repurchases of the company’s common stock. This brings the total outstanding authorization up to $5.8B. By its terms, repurchases under the 2021 Repurchase Program will commence upon completion of the 2018 Repurchase Program and will expire when all authorized funds for repurchases have been used.

The table below summarizes the company’s share repurchases to date under the authorizations described above.

The FY2011 - 2020 average shares outstanding are (in millions of shares): 282, 253, 234, 212, 192, 181, 176, 175, 170, and 168. The weighted average diluted shares outstanding at the end of Q1 2021 is 163.5 million. As noted earlier, NOC executed a $2B accelerated share repurchase agreement that retired an initial 5.9 million shares. Some of the proceeds for this accelerated share repurchase came from the sale of the IT and mission support services business.

Northrop Grumman - Stock Analysis - Valuation

Acquiring shares at a reasonable valuation, especially when the dividend yield is low, is of utmost importance. This is why I focus on an investment's potential overall return and not dividend yield.

NOC's FY2011 - 2020 diluted EPS are $7.52, $7.81, $8.35, $9.75, $10.39, $11.32, $16.34, $18.49, $13.22, and $19.03. Its GAAP diluted PE level over the same timeframe is 8.56, 8.65, 13.71, 15.66, 18.22, 19.83, 22.87, 15.67, 19.44, and 20.77.

In Q1, NOC generated $13.43 of diluted EPS and is expected to generate FY2021 Mark to market-adjusted EPS of $30.90 - $31.40. This figure, however, includes the one-time gain from the sale of the IT and mission support services business and other adjustments. Using the mid-point of management's $24 - $24.50 FY2021 adjusted diluted EPS guidance, we get a forward adjusted diluted PE of ~15.14. This is based on the current ~$367.20 share price and also excludes the impact of the one-time gain.

Adjusted diluted EPS guidance from 18 brokers for FY2021 and 20 brokers for FY2022 is fairly wide-ranging.

  • FY2021 adjusted diluted EPS is a mean of $24.54 and a $23.69 - $25.09 range. With shares trading at ~$367.20, the forward adjusted diluted PE is ~15 using the mean value.
  • FY2022 adjusted diluted EPS is a mean of $25.63 and a $23.90 - $28.10 range. With shares trading at ~$367.20, the forward adjusted diluted PE is ~14.33 using the mean value.

NOC's valuation appears reasonable based on management's and brokers' guidance.

Northrop Grumman - Stock Analysis - Final Thoughts

Although I view NOC's valuation to be reasonable, I continue to expect a broad market pullback. I am, therefore, patiently waiting for NOC's share price to retrace further from the ~$379 high set at the end of May 2021. If shares retrace to $350 or lower, I intend to initiate a position.

Stay safe. Stay focused.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I do not have exposure to NOC and intend to initiate a position when shares retrace to ~$350 or lower. I am long LMT, RTX, and HEI-a.

Disclaimer: I do not know your individual circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your own research and due diligence. Consult your financial advisor about your specific situation.